Housing About To Leg Down: 2 Buys, 3 Sells, And A Hedge

The homebuilders have had an amazing run over the last six months. Returns have ranged from a 'pitiful' 77.8% for DR Horton (DHI) to almost double that at 144.9% for PulteGroup (PHM). While the housing market seems to have bottomed, recent data suggests the rebound has moderated a little. This, combined with some possible market headwinds, means you might want to adjust your exposure to keep from losing those gains.

While pending home sales released last week were still close to a one-year high, February's sales dipped 0.5% from the month before. Worse, some of the strong demand over the winter will probably come at the expense of the spring-time seller's season. The Case-Shiller index fell again in January, though only 0.04% for the smallest decline since last July.

Tuesday's release of the minutes for the March 13th meeting of the Federal Open Market Committee (FOMC) were not housing friendly, though may not be as bad as the market reaction implies. The market reacted to a slightly more positive tone and a pullback in the possibility of another round of quantitative easing. Needed or not, housing will benefit from QE3 through its role as inflation-protection and additional support for the mortgage-backed securities (MBS) market.

The reaction to the meeting minutes may have been a bit severe, especially in the treasuries market. The market seems to be fixating on statements by traditionally hawkish Fed members, notably Atlanta Fed President Lockhart with the statement, "I would have to see some pretty severe circumstances before I endorse another round of quantitative easing." Markets may be overlooking the Fed's dovish slant in voting members, especially in Chairman Bernanke.

The Federal Reserve is decidedly more accommodative this year with the non-voting status of several hawks, detailed in an article in December. Most obvious in the minutes was the Fed's acknowledgement that weak economic growth may be dependent on a continuing accommodative policy with, "real GDP growth would pick up only gradually in 2012 and 2013, supported by accommodative monetary policy, easing credit conditions, and improvements in consumer and business sentiment."

Most damaging to the housing market may be the 1.25 million foreclosed homes that could be coming to the market soon. Bloomberg reports on Tuesday that the recent resolution of bank foreclosure practices. The article estimates that sales of foreclosed homes could rise by 25% this year from last year's already high amount. While recent data seems to suggest that price declines have slowed, Moody's Analytics estimates that home prices could drop as much as 10% because of the increased supply of foreclosures on the market.

Investors may want to hedge their exposure or protect gains in their housing-related investments. Some exposure to housing is still reasonable given upward momentum but seek safety in quality companies and hedging strategies.

High beta stocks, those with higher volatility relative to the general market, will decrease faster than others in the event of a sell-off. Similarly, investors should look to companies with positive earnings yield for protection. Earnings yield, or trailing earnings divided by price, is a useful metric when comparing companies with negative earnings.

Though Home Depot (HD) is not a homebuilder, it has obvious exposure to the market and will stand to gain from a rebound in housing. Additionally, the home-improvement powerhouse will benefit from the mass of foreclosures coming to market as owners look to fix up properties.

Of the homebuilders, Lennar Corporation (LEN) is the only with a positive earnings yield and one of the lower betas. Shares should lose less in the event of weakness in the market. This is in stark contrast to shares of Hovanian (HOV) with the second highest beta and an extremely negative earnings yield. Beazer Homes (BZH) and PulteGroup, both with high betas and negative earnings yields, have seen their share prices skyrocket and may give back a good portion of gains.

DR Horton may be a candidate for a hedging strategy as the lower beta and earnings yield suggest some strength relative to the three weaker companies. Investors could sell put options against a holding in DR Horton to protect against price declines, or use a long position in DHI against a short position in one of the three weaker companies.

Beta and earnings yield are not the only factors that will affect these stocks in the event of market weakness. Investors should look to each company's exposure to different regional markets and information on the number of estimated foreclosures coming to market in each state. Sales and construction of homes are still at extremely low levels and there is still a lot of room for the market to recover. Investors should evaluate their own fair value estimates given different scenarios and decide if short-term weakness presents a buy opportunity.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.